Price adjustments under fixed exchange rate, Microeconomics

Assignment Help:

PRICE ADJUSTMENTS UNDER FIXED EXCHANGE RATE:

In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.


Related Discussions:- Price adjustments under fixed exchange rate

What are possible negative consequences of economic growth, What are the po...

What are the possible negative consequences of economic growth in a developing country? Define economic growth as an enhance in GDP during a given time period, and then define

Point elasticity of demand for demand function Q=10-2p, calculate point ela...

calculate point elasticity of demand function Q=10-2p for decrease in price from Rs3 to Rs2

Explain about the determination of equilibria, Explain about the determinat...

Explain about the determination of equilibria. Determination of Equilibria: The fourth step for studying an economic step is to make trade-off choices and find out the be

What are the parts of valuable economics paper, What are the parts of valua...

What are the parts of valuable economics paper? The consequence of economics research is an economic conclusion. Usually a valuable economics paper comprises three parts: a.

Engel curves, Engel Curves -Engel curves relate quantity of good consum...

Engel Curves -Engel curves relate quantity of good consumed to income. -If good is a normal good, Engel curve is sloping upward. -If good is an inferior good, the Engel c

Example of consumer surplus, Example: The Value of Clean Air Air is fre...

Example: The Value of Clean Air Air is free in sense that we do not pay to breathe it. Question: Are benefits of cleaning up air worth the costs? People pay extra to buy

Multiplier, what is dynamic and static multipler

what is dynamic and static multipler

Physical capital, Physical Capital: A tangible tool, machine, building or o...

Physical Capital: A tangible tool, machine, building or other productive asset that is used to produce other goods or services. Pollution: Many economic activities involve disch

Determine the cross elasticity of demand, Determine the Cross Elasticity of...

Determine the Cross Elasticity of Demand Measures the responsiveness of demand for good A to a given change in the price of good B. It is an significant piece of information to

Explain the different types of unemployment that exist, Problem 1: a) E...

Problem 1: a) Explain the different types of unemployment that exist. b) Critically examine how monetary policy can be used to deal with inflation. c) Critically examine

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd